Budget and Planning Interview Questions & Answers

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It can be daunting to start the process of creating a budget, especially if you're not familiar with some of the common accounting and budget terminology you will encounter, so we have provided a glossary of terms covered here, located toward the bottom of the page under the In Summary section of the page.

It is important for organizations to create accurate and up-to-date annual budgets in order to maintain control over their finances, and to show funders exactly how their money is being used. How specific and complex the actual budget document needs to be depends on how large the budget is, how many funders you have and what their requirements are, how many different programs or activities you're using the money for, etc. At some level, however, your budget will need to include the following:

Projected expenses. The amount of money you expect to spend in the coming fiscal year, broken down into the categories you expect to spend it in - salaries, office expenses, etc.

Fiscal year simply means "financial year," and is the calendar you use to figure your yearly budget, and which determines when you file tax forms, get audited, and close your books. There are many different fiscal years you can use. Businesses often use the calendar year -- January 1 to December 31. The federal government's fiscal year runs from October 1 to September 30. State governments -- and therefore state agencies and many community-based and non-profit organizations that receive state funding - usually use July 1 to June 30. Most organizations adopt a fiscal year that fits with that of their major funders. You'll want to prepare your budget specifically to cover your fiscal year, and to have it ready before the fiscal year begins. In many organizations, the Board of Directors needs to approve a budget before the beginning of the fiscal year in order for the organization to operate.

Projected income. The amount of money you expect to take in for the coming fiscal year, broken down by sources -- i.e. the amount you expect from each funding source, including not only grants and contracts, but also your own fundraising efforts, memberships, and sales of goods or services.

The interaction of expenses and income. What gets funded from which sources? In many cases, this is a condition of the funding: a funder agrees to provide money for a specific position, for instance, or for particular activities or items. If funding comes with restrictions, it's important to build those restrictions into your budget, so that you can make sure to spend the money as you've told the funder you would.

Adjustments to reflect reality as the year goes on. Your budget will likely begin with estimates, and as the year progresses, those estimates need to be adjusted to be as accurate as possible to keep track of what's really happening.

It gives you the real picture - by accurately showing you what you can afford and where the gaps in funding are, your budget allows you to plan beforehand to meet needs, and to decide what you're actually able to do in a given year

It encourages effective ways of dealing with money issues - by showing you what you can't afford with known income, a budget can motivate you to be creative - and successful - in seeking out other sources of funding

It fills the need for required information - the completed budget is a necessary element of funding proposals and reports to funders and the community

It facilitates discussion of the financial realities of the organization

Continuous budgeting is the process of continually adding one more month to the end of a multi-period budget as each month goes by. This approach has the advantage of having someone constantly attend to the budget model and revise budget assumptions for the last incremental period of the budget. The downside of this approach is that it may not yield a budget that is more achievable than the traditional static budget, since the budget periods prior to the incremental month just added are not revised.

The continuous budgeting concept is usually applied to a twelve-month budget, so there is always a full year budget in place. However, the period of this budget may not correspond to a company's fiscal year.

If a company elects to use continuous budgeting for a smaller time period, such as three months, its ability to create a high-quality budget is greatly enhanced. Sales forecasts tend to be much more accurate over periods of just a few months, so the budget can be revised based on very likely estimates of company activity. Over such a short period of time, a continuous budget is essentially the same as a short-term forecast, except that a forecast tends to produce more aggregated revenue and expense numbers.

Continuous budgeting calls for considerably more management attention than is the case when a company produces a one-year static budget, since some budgeting activities must now be repeated every month. In addition, if a company uses participative budgeting to create its budgets on a continuous basis, then the total employee time used over the course of a year is substantial. Consequently, it is best to adopt a leaner approach to continuous budgeting, with fewer people involved in the process.

If continuous budgeting principles are applied to capital budgeting, this means that funds may be granted for large fixed asset projects at any time, rather than during the more typical once-a-year capital budgeting process that is prevalent under more traditional budgeting systems.

A business creates a budget when it wants to match its actual future performance to an ideal scenario that incorporates its best estimates of sales, expenses, asset replacements, cash flows, and other factors. There are a number of alternative budgeting models available.

The following list summarizes the key aspects and disadvantages of each type of budgeting model:

Static budgeting. This is the classic form of budgeting, where a business creates a model of its expected results and financial position for the next year, and then attempts to force actual results during that period to align with the budget model as closely as possible. This budget format is typically based on a single expected outcome, which can be extremely difficult to achieve. It also tends to introduce a great deal of rigidity into an organization, rather than allowing it to react quickly to ongoing changes in its environment.

Zero-base budgeting. A zero-base budget involves determining what outcomes management wants, and developing a package of expenditures that will support each outcome. By combining the various outcome-expenditure packages, a budget is derived that should result in a specific set of outcomes for the entire business. This approach is most useful in service-level entities, such as governments, where the provision of services is paramount. However, it also takes a considerable amount of time to develop, in comparison to the static budget.

Flexible budgeting. A flexible budget model allows you to enter different sales levels in the model, whch will then adjust planned expense levels to match the sales levels that have been entered. This approach is useful when sales levels are difficult to estimate, and a significant proportion of expenses vary with sales. This type of model is more difficult to prepare than a static budget model, but tends to yield a budget that is reasonably comparable to actual results.

Incremental budgeting. Incremental budgeting is an easy way to update a budget model, since it assumes that what has happened in the past can be rolled forward into the future. Though this approach results in simplified budget updates, it does not provoke a detailed examination of company efficiencies and expenditures, and so does not assist in the creation of a lean and efficient enterprise.

The rolling budget. A rolling budget requires that a new budget period be added as soon as the most recent period has been completed. By doing so, the budget always extends a uniform distance into the future. However, it also requires a considerable amount of budgeting work in every accounting period to formulate the next incremental update. Thus, it is the least efficient budgeting alternative, though it does focus ongoing attention on the budget.

The rolling forecast. A rolling forecast is not really a budget, but rather a regular update to the sales forecast, frequently on a monthly basis. The organization then models its short-term spending on the expected revenue level. This approach has the advantages of being very easy to update, and requiring no budgeting infrastructure.

Of the budgeting models shown here, the static model is by far the most common, despite being unwieldy and rarely attained. A considerably different alternative is to use a rolling forecast, and allow managers to adjust their expenditures "on the fly" to match short-term revenue expectations. Organizations may find that the rolling forecast is a more productive form of budget model, given its high degree of flexibility.

In essence, a budget is a quantified expectation for what a business wants to achieve. Its characteristics are:

The budget is a detailed representation of the future results, financial position, and cash flows that management wants the business to achieve during a certain period of time.

The budget may only be updated once a year, depending on how frequently senior management wants to revise information.

The budget is compared to actual results to determine variances from expected performance.

Management takes remedial steps to bring actual results back into line with the budget.

The budget to actual comparison can trigger changes in performance-based compensation paid to employees.

Conversely, a forecast is an estimate of what will actually be achieved. Its characteristics are:

The forecast is typically limited to major revenue and expense line items. There is usually no forecast for financial position, though cash flows may be forecasted.

The forecast is updated at regular intervals, perhaps monthly or quarterly.

The forecast may be used for short-term operational considerations, such as adjustments to staffing, inventory levels, and the production plan.

There is no variance analysis that compares the forecast to actual results.

Changes in the forecast do not impact performance-based compensation paid to employees.

Thus, the key difference between a budget and a forecast is that the budget is a plan for where a business wants to go, while a forecast is the indication of where it is actually going.

Realistically, the more useful of these tools is the forecast, for it gives a short-term representation of the actual circumstances in which a business finds itself. The information in a forecast can be used to take immediate action. A budget, on the other hand, may contain targets that are simply not achievable, or for which market circumstances have changed so much that it is not wise to attempt to achieve. If a budget is to be used, it should at least be updated more frequently than once a year, so that it bears some relationship to current market realities. The last point is of particular importance in a rapidly-changing market, where the assumptions used to create a budget may be rendered obsolete within a few months.

In short, a business always needs a forecast to reveal its current direction, while the use of a budget is not always necessary.

Many organizations prepare budgets that they use as a method of comparison when evaluating their actual results over the next year. The process of preparing a budget should be highly regimented and follow a set schedule, so that the completed budget is ready for use by the beginning of the next fiscal year.

Here are the basic steps to follow when preparing a budget:

Update budget assumptions. Review the assumptions about the company's business environment that were used as the basis for the last budget, and update as necessary.

Review bottlenecks. Determine the capacity level of the primary bottleneck that is constraining the company from generating further sales, and define how this will impact any additional company revenue growth.

Available funding. Determine the most likely amount of funding that will be available during the budget period, which may limit growth plans.

Step costing points. Determine whether any step costs will be incurred during the likely range of business activity in the upcoming budget period, and define the amount of these costs and at what activity levels they will be incurred.

Create budget package. Copy forward the basic budgeting instructions from the instruction packet used in the preceding year. Update it by including the year-to-date actual expenses incurred in the current year, and also annualize this information for the full current year. Add a commentary to the packet, stating step costing information, bottlenecks, and expected funding limitations for the upcoming budget year.

Issue budget package. Issue the budget package personally, where possible, and answer any questions from recipients. Also state the due date for the first draft of the budget package.

Obtain revenue forecast. Obtain the revenue forecast from the sales manager, validate it with the CEO, and then distribute it to the other department managers. They use the revenue information as the basis for developing their own budgets.

Obtain department budgets. Obtain the budgets from all departments, check for errors, and compare to the bottleneck, funding, and step costing constraints. Adjust the budgets as necessary.

Obtain capital budget requests. Validate all capital budget requests and forward them to the senior management team with comments and recommendations.

Update the budget model. Input all budget information into the master budget model.

Review the budget. Meet with the senior management team to review the budget. Highlight possible constraint issues, and any limitations caused by funding limitations. Note all comments made by the management team, and forward this information back to the budget originators, with requests to modify their budgets.

Process budget iterations. Track outstanding budget change requests, and update the budget model with new iterations as they arrive.

Issue the budget. Create a bound version of the budget and distribute it to all authorized recipients.

Load the budget. Load the budget information into the financial software, so that you can generate budget versus actual reports.

The number of steps noted here may be excessive for a smaller business, where perhaps just one person is involved in the process. If so, the number of steps can be greatly compressed, to the point where a preliminary budget can possibly be prepared in a day or two.

Incremental budgeting is budgeting based on slight changes from the preceding period's budgeted results or actual results. This is a common approach in businesses where management does not intend to spend a great deal of time formulating budgets, or where it does not perceive any great need to conduct a thorough re-evaluation of the business. This mindset typically occurs when there is not a great deal of competition in an industry, so that profits tend to be perpetuated from year to year.

There are several advantages to incremental budgeting, which are as follows:

Simplicity. The primary advantage is the simiplicity of incremental budgeting, being based on either recent financial results or a recent budget that can be readily verified.

Funding stability. If a program requires funding for multiple years in order to achieve a certain outcome, incremental budgeting is structured to ensure that funds will keep flowing to the program.

Operational stability. This approach ensures that departments are operated in a consistent and stable manner for long periods of time.

Participative budgeting is a budgeting process under which those people impacted by a budget are actively involved in the budget creation process.

This bottom-up approach to budgeting tends to create budgets that are more achievable than are top-down budgets that are imposed on a company by senior management, with much less participation by employees. Participatory budgeting is also better for morale, and tends to result in greater efforts by employees to achieve what they predicted in the budget. However, a purely participative budget does not take high-level strategic considerations into account, so management needs to provide employees with guidelines regarding the overall direction of the company, and how their individual departments fit into that direction.

When participative budgeting is used throughout an organization, the preliminary budgets work their way up through the corporate heirarchy, being reviewed and possibly modified by mid-level managers along the way. Once assembled into a single master budget, it may become apparent that the submitted budgets will not work together, in which case they are sent back down to the originators for another iteration, usually with guidelines noting what senior management is looking for.

Because of the larger number of employees involved in participatory budgeting, it tends to take longer to create a budget than is the case with a top-down budget that may be created by a much smaller number of people. The labor cost associated with creating such a budget is also relatively high.

Another problem with participative budgeting is that, since the people originating the budget are also the ones whose performance will be compared to it, there is a tendency for participants to adopt a conservative budget with extra expense padding, so that they are reasonably assured of achieving what they predict in the budget. This tendency is more pronounced when employees are paid bonuses based on their performance against the budget.

This problem of budgetary slack can be mitigated by imposing a review of the budgets by those members of management who are most likely to know when budgets are being padded, and who are allowed to make adjustments to the budget as needed. Only by following this approach can stretch goals be integrated into a budget.

Many companies go through the budgeting process every year simply because they did it the year before, but they do not know why they continue to create new budgets.

What are the objectives of budgeting? They are:

Provide structure. A budget is especially useful for giving a company guidance regarding the direction in which it is supposed to be going. Thus, it forms the basis for planning what to do next. A CEO would be well advised to impose a budget on a company that does not have a good sense of direction. Of course, a budget will not provide much structure if the CEO promptly files away the budget and does not review it again until the next year. A budget only provides a significant amount of structure when management refers to it constantly, and judges employee performance based on the expectations outlined within it.

Predict cash flows. A budget is extremely useful in companies that are growing rapidly, that have seasonal sales, or which have irregular sales patterns. These companies have a difficult time estimating how much cash they are likely to have in the near term, which results in periodic cash-related crises. A budget is useful for predicting cash flows, but yields increasingly unreliable results further into the future. Thus, providing a view of cash flows is only a reasonable budgeting objective if it covers the next few months of the budget.

Allocate resources. Some companies use the budgeting process as a tool for deciding where to allocate funds to various activities, such as fixed asset purchases. Though a valid objective, it should be combined with capacity constraint analysis (which is more of an industrial engineering function than a financial function) to determine where resources should really be allocated.

Model scenarios. If a company is faced with a number of possible paths down which it can travel, you can create a set of budgets, each based on different scenarios, to estimate the financial results of each strategic direction. Though useful, this objective can result in highly unlikely results if management lets itself become overly optimistic in inputting assumptions into the budget model.

Measure performance. A common objective in creating a budget is to use it as the basis for judging employee performance, through the use of variances from the budget. This is a treacherous objective, since employees attempt to modify the budget to make their personal objectives easier to achieve (known as budgetary slack).

Conversely, budgeting may not be of much use for a well-established business that has a consistent track record of performance. In this case, a better approach may be to manage the organization from a rolling forecast that is updated on a regular basis. Doing so reduces the work associated with financial predictions, and also allows the business to shift its operational focus on short notice.

A budget forecasts the financial results and financial position of a company for one or more future periods. A budget is used for planning and performance measurement purposes, which can involve spending for fixed assets, rolling out new products, training employees, setting up bonus plans, controlling operations, and so forth.

At the most minimal level, a budget contains an estimated income statement for future periods. A more complex budget contains a sales forecast, the cost of goods sold and expenditures needed to support the projected sales, estimates of working capital requirements, fixed asset purchases, a cash flow forecast, and an estimate of financing needs. This should be constructed in a top-down format, so a master budget contains a summary of the entire budget document, while separate documents containing supporting budgets roll up into the master budget, and provide additional detail to users.

Many budgets are prepared on electronic spreadsheets, though larger businesses prefer to use budget-specific software that is more structured and so is less liable to contain computational errors.

A prime use of the budget is as a performance baseline for the measurement of actual results. It can be misleading to do so, since budgets typically become increasingly inaccurate over time, resulting in large variances that have no basis in actual results. To reduce this problem, some companies periodically revise their budgets to keep them closer to reality, or only budget for a few periods into the future, which gives the same result.

Another option that sidesteps budgeting problems is to operate without a budget. Doing so requires an ongoing short-term forecast from which business decisions can be made, as well as performance measurements based on what a peer group is achieving. Though operating without a budget can at first appear to be too slipshod to be effective, the systems that replace a budget can be remarkably effective.

and the actual amount. The budget variance is favorable when the actual revenue is higher than the budget or when the actual expense is less than the budget.

In rare cases, the budget variance can also refer to the difference between actual and budgeted assets and liabilities.

A budget variance is frequently caused by bad assumptions or improper budgeting (such as using politics to derive an unusually easy budget target), so that the baseline against which actual results are measured is not reasonable.

Those budget variances that are controllable are usually expenses, though a large portion of expenses may be committed expenses that cannot be altered in the short term. Truly controllable expenses are discretionary expenses, which can be eliminated without an immediate adverse impact on profits.

Those budget variances that are uncontrollable usually originate in the marketplace, when customers do not buy the company's products in the quantities or at the price points anticipated in the budget. The result is actual revenues that may vary substantially from expectations.

Some budget variances can be eliminated through the simple aggregation of line items in the budget. For example, if there is a negative electricity budget variance of $2,000 and a positive telephone expense budget variance of $3,000, the two line items could be combined for reporting purposes into a utilities line item that has a net positive variance of $1,000.

As an example of a budget variance, ABC Company had budgeted $400,000 of selling and administrative expenses, and actual expenses are $420,000. Thus, there is an unfavorable budget variance of $20,000. However, the budget used as the baseline for this calculation did not include a scheduled rent increase of $25,000, so a flaw in the budget caused the variance, rather than any improper management actions.

Budgetary slack is the deliberate under-estimation of budgeted revenue or over-estimation of budgeted expenses. This allows managers a much better chance of "making their numbers," which is particularly important for them if performance appraisals and bonuses are tied to the achievement of budgeted numbers.

Budgetary slack may also occur when there is considerable uncertainty about the results to be expected in a future period. Managers tend to be more conservative when creating budgets under such circumstances. This is particularly common when creating a budget for an entirely new product line, where there is no historical record of possible results to rely upon.

Budgetary slack is most common when a company uses participative budgeting, since this form of budgeting involves the participation of a large number of employees, which gives more people a chance to introduce budgetary slack into the budget.

Another source of budgetary slack is when senior management wants to report to the investment community that the business is routinely beating internal budget expectations. This cause is less likely, since outside analysts judge a company's performance in relation to the results of its competitors, not its budget.

Budgetary slack interferes with proper corporate performance, because employees only have an incentive to meet their budget goals, which are set quite low. When there is budgetary slack for multiple consecutive years, a company may find that its overall performance has declined in comparison to that of more aggressive competititors who use stretch goals. Thus, budgetary slack can have a long-term negative impact on the profitability and competitive positioning of a business.

Budgetary slack is less likely to occur when a small number of aggressive managers are the only ones allowed input into the budget model, since they can set expectations extremely high. Slack is also less likely when there is no link between performance or bonus plans and the budget.

A zero-base budget requires managers to justify all of their budgeted expenditures, rather than the more common approach of only requiring justification for incremental changes to the budget or the actual results from the preceding year. Thus, a manager is theoretically assumed to have an expenditure base line of zero (hence the name of the budgeting method).

In reality, a manager is assumed to have a minimum amount of funding for basic departmental operations, above which additional funding must be justified. The intent of the process is to continually refocus funding on key business objectives, and terminate or scale back any activities no longer related to those objectives.

The basic process flow under zero-base budgeting is:

Identify business objectives

Create and evaluate alternative methods for accomplishing each objective

The concept of paring back expenses in layers can also be used in reverse, where you delineate the specific costs and capital investment that will be incurred if you add an additional service or function. Thus, management can make discrete determinations of the exact combination of incremental cost and service for their business. This process will typically result in at least a minimum service level, which establishes a cost baseline below which it is impossible for a business to go, along with various gradations of service above the minimum.

There are a number of advantages to zero-base budgeting, which include:

Alternatives analysis. Zero-base budgeting requires that managers identify alternative ways to perform each activity (such as keeping it in-house or outsourcing it), as well as the effects of different levels of spending. By forcing the development of these alternatives, the process makes managers consider other ways to run the business.

Budget inflation. Since managers must tie expenditures to activities, it becomes less likely that they can artificially inflate their budgets – the change is too easy to spot.

Communication. The zero-base budget should spark a significant debate among the management team about the corporate mission and how it is to be achieved.

Eliminate non-key activities. A zero-base budget review forces managers to decide which activities are most critical to the company. By doing so, they can target non-key activities for elimination or outsourcing.

Mission focus. Since the zero-base budgeting concept requires managers to link expenditures to activities, they are forced to define the various missions of their departments – which might otherwise be poorly defined.

Redundancy identification. The review may reveal that the same activities are being conducted by multiple departments, leading to the elimination of the activity outside of the area where management wants it to be centered.

Required review. Using zero-base budgeting on a regular basis makes it more likely that all aspects of a company will be examined periodically.

Resource allocation. If the process is conducted with the overall corporate mission and objectives in mind, an organization should end up with strong targeting of funds in those areas where they are most needed.

In short, many of the advantages of zero-base budgeting focus on a strong, introspective look at the mission of a business and exactly how the business is allocating its resources in order to achieve that mission.

The main downside of zero-base budgeting is the exceptionally high level of effort required to investigate and document department activities; this is a difficult task even once a year, which causes some entities to only use the procedure once every few years, or when there are significant changes within the organization. Another alternative is to require the use of zero-base budgeting on a rolling basis through different parts of a company over several years, so that management can deal with fewer such reviews per year. Other drawbacks are:

Bureaucracy. Creating a zero-base budget from the ground up on a continuing basis calls for an enormous amount of analysis, meetings, and reports, all of which requires additional staff to manage the process.

Gamesmanship. Some managers may attempt to skew their budget reports to concentrate expenditures under the most vital activities, thereby ensuring that their budgets will not be reduced.

Intangible justifications. It can be difficult to determine or justify expenditure levels for areas of a business that do not produce “concrete,” tangible results. For example, what is the correct amount of marketing expense, and how much should be invested in research and development activities?

Training. Managers require significant training in the zero-base budgeting process, which further increases the time required each year.

Update speed. The extra effort required to create a zero-base budget makes it even less likely that the management team will revise the budget on a continuous basis to make it more relevant to the competitive situation.

A static budget is fixed for the entire period covered by the budget, with no changes based on actual activity. Thus, even if actual sales volume changes significantly from the expectations documented in the static budget, the amounts listed in the budget are not changed.

A static budget model is most useful when a company has highly predictable sales and expenses that are not expected to change much through the budgeting period (such as in a monopoly situation). In more fluid environments where operating results could change substantially, a static budget can be a hindrance, since actual results may be compared to a budget that is no longer relevant.

The static budget is used as the basis from which actual results are compared. The resulting variance is called a static budget variance. Static budgets are commonly used as the basis for evaluating sales performance. However, they are not effective for evaluating the performance of cost centers. For example, a cost center manager may be given a large static budget, and will make expenditures below the static budget and be rewarded for doing so, even though a much larger overall decline in company revenues should have mandated a much larger expense reduction. The same problem arises if revenues are much higher than expected - the managers of cost centers have to spend more than the amounts indicated in the baseline static budget, and so appear to have unfavorable variances, even though they are simply doing what is needed to keep up with customer demand.

A common result of using a static budget as the basis for a variance analysis is that the variances can be quite substantial, especially for those budget periods furthest in the future, since it is difficult to make accurate predictions for more than a few months. These variances are much smaller if a flexible budget is used instead, since a flexible budget is adjusted to take account of changes in actual sales volume.

For example, ABC Company creates a static budget in which revenues are forecasted to be $10 million, and the cost of goods sold to be $4 million. Actual sales are $8 million, which represents an unfavorable static budget variance of $2 million. The actual cost of goods sold is $3.2 million, which is a favorable static budget variance of $800,000. If the company had used a flexible budget instead, the cost of goods sold would have been set at 40% of sales, and would accordingly have dropped from $4 million to $3.2 million when actual sales declined. This would have resulted in both the actual and budgeted cost of goods sold being the same, so that there would be no cost of goods sold variance at all.

A rolling budget is continually updated to add a new budget period as the most recent budget period is completed. Thus, the rolling budget involves the incremental extension of the existing budget model. By doing so, a business always has a budget that extends one year into the future.

A rolling budget calls for considerably more management attention than is the case when a company produces a one-year static budget, since some budgeting activities must now be repeated every month. In addition, if a company uses participative budgeting to create its budgets on a rolling basis, the total employee time used over the course of a year is substantial. Consequently, it is best to adopt a leaner approach to a rolling budget, with fewer people involved in the process.

Advantages and Disadvantages of the Rolling Budget

This approach has the advantage of having someone constantly attend to the budget model and revise budget assumptions for the last incremental period of the budget. The downside of this approach is that it may not yield a budget that is more achievable than the traditional static budget, since the budget periods prior to the incremental month just added are not revised.

Example of a Rolling Budget

ABC Company has adopted a 12-month planning horizon, and its initial budget is from January to December. After a month passes, the January period is complete, so it now added a budget for the following January, so that it still has a 12-month planning horizon that now extends from February of the current year to January of the next year.

A fixed budget is a financial plan that does not change through the budget period, irrespective of any changes in actual activity levels experienced.

Since most companies experience substantial variations from their expected activity levels over the period encompassed by a budget, the amounts in the budget are likely to diverge from actual results. This divergence is likely to increase over time. The only situations in which a fixed budget is likely to track close to actual results are when:

Costs are largely fixed, so that expenses do not change as revenues fluctuate

The industry is not subject to much change, so that revenues are reasonably predictable

The company is in a monopoly situation, where customers must accept its pricing

Most companies use fixed budgets, which means that they routinely deal with large variations between actual and budgeted results. This also tends to cause a lack of reliance by employees on the budget, and in the variances derived from it.

A good way to mitigate the disadvantages of a fixed budget are to combine it with continuous budgeting, where you add a new budget period onto the end of the budget as soon as the most recent budget period has been concluded. By doing so, you gradually incorporate the actual results of the most recent period into the budget, and also maintain a full-year budget at all times.

Another way to mitigate the effects of a fixed budget is to shorten the period covered by it. For example, the budget may only encompass a three-month period, after which management formulates another budget that lasts for an additional three months. Thus, even though the amounts in the budget are fixed, they apply to such a short period of time that actual results will not have much time in which to diverge from expectations.

The fixed budget is not effective for evaluating the performance of cost centers. For example, a cost center manager may be given a large fixed budget, and will make expenditures below the budget and be rewarded for doing so, even though a much larger overall decline in company revenues should have mandated a much larger expense reduction. The same problem arises if revenues are much higher than expected - the managers of cost centers have to spend more than the amounts indicated in the baseline fixed budget, and so appear to have unfavorable variances, even though they are simply doing what is needed to keep up with customer demand.

The reverse of a fixed budget is a flexible budget, where the budget is designed to change in response to variations in activity levels. There tend to be much smaller variances from the budget when a flexible budget is used, since the model tracks much closer to actual results.

A flexible budget includes formulas that adjust expenses based on changes in actual revenue or other activities. The result is a budget that is fairly closely aligned with actual results. This approach varies from the more common static budget, which contains nothing but fixed expense amounts that do not vary with actual revenue levels.

In its simplest form, the flex budget uses percentages of revenue for certain expenses, rather than the usual fixed numbers. This allows for an infinite series of changes in budgeted expenses that are directly tied to actual revenue incurred. However, this approach ignores changes to other costs that do not change in accordance with small revenue variations. Consequently, a more sophisticated format will also incorporate changes to many additional expenses when certain larger revenue changes occur, thereby accounting for step costs. By incorporating these changes into the budget, a company will have a tool for comparing actual to budgeted performance at many levels of activity.

Advantages of Flexible Budgeting :

Since the flexible budget restructures itself based on activity levels, it is a good tool for evaluating the performance of managers - the budget should closely align to expectations at any number of activity levels. It is also a useful planning tool for managers, who can use it to model the likely financial results at a variety of different activity levels.

Disadvantages of Flexible Budgeting :

Though the flex budget is a good tool, it can be difficult to formulate and administer. Several issues are:

Many costs are not fully variable, instead having a fixed cost component that must be derived and then included in the flex budget formula.

A great deal of time can be spent developing step costs, which is more time than the typical accounting staff has available, especially when in the midst of creating the more traditional static budget. Consequently, the flex budget tends to include only a small number of step costs, as well as variable costs whose fixed cost components are not fully recognized.

The flexible budget model usually only works within a relatively limited revenue range; the budget analyst is unlikely to spend the time developing a more wide-ranging model if it is considered unlikely that outlier revenue amounts will be encountered.

There may also be a time delay between when there is a change in revenue and when a supposedly variable cost changes. Here are several examples:

Sales increase, but factory overhead costs do not increase at a similar rate, since the sales are from inventory that was produced in a prior period.

Sales increase, but commissions do not increase at a similar rate, since the commissions are based on cash received, which has a 30-day time lag.

Sales decline, but direct labor costs do not decline at the same rate, because management elected to retain the production staff.

Given the considerable amount of time required to maintain a flexible budget, some organizations may instead opt to eliminate their budgets entirely, in favor of using short-range forecasting without the use of any types of standards (flexible or otherwise). An alternative is to run a high-level flex budget as a pilot test to see how useful the concept is, and then expand the model as necessary.

Example of a Flexible Budget

ABC Company has a budget of $10 million in revenues and a $4 million cost of goods sold. Of the $4 million in budgeted cost of goods sold, $1 million is fixed, and $3 million varies directly with revenue. Thus, the variable portion of the cost of goods sold is 30% of revenues. Once the budget period has been completed, ABC finds that sales were actually $9 million. If it used a flexible budget, the fixed portion of the cost of goods sold would still be $1 million, but the variable portion would drop to $2.7 million, since it is always 30% of revenues. The result is that a flexible budget yields a budgeted cost of goods sold of $3.7 million at a $9 million revenue level, rather than the $4 million that would be listed in a static budget.

Most companies prepare just a single budget scenario, which is their best guess regarding how the next year will turn out. This scenario is based upon a range of supporting assumptions, any one of which can lead to diverging results - and usually does. So, though you may spend a considerable amount of time on that "mainstream" budget scenario, just that one version will not be enough to prepare you for what may - and probably will - happen.

It makes sense to add two more scenarios, one for the absolute worst case, where bankruptcy is looming, and one for the most phenomenal sales success. Sounds unlikely that either one will ever happen? If you don't plan for success, it never will happen, and bankruptcy scenarios are far more frequent than you might think. Consequently, it is useful to know what resources you'll need for a phenomenally successful year, and how deep you will have to cut to avoid bankruptcy. Is that enough scenarios? No.

There are gaping holes between the two opposite-extreme scenarios and the mainstream version. Realistically, actual results will fall into either of those two holes, so you should spend some time figuring out what you will do for situations that are somewhat above and below the mainstream scenario.

So the answer is - five budget scenarios. However, if some of your underlying assumptions are more likely than not to occur or to fail, then you may want to drum up some extra models just for those specific situations.

All of this talk of multiple models does not mean that you should spend an equal amount of time on each one. The mainstream scenario requires the most work, because it is (presumably) the most likely, with less work needed for the less likely ones. Nonetheless, you should at least spend time determining financial results at a high level for each scenario, and conceptualize what those situations will do to the company's operations.

Budgetary planning is the process of constructing a budget and then utilizing it to control the operations of a business. The purpose of budgetary planning is to mitigate the risk that an organization's financial results will be worse than expected.

The first step in budgetary planning is to construct a budget. This is accomplished by engaging in the following tasks, which are presented in their approximate order:

Obtain strategic direction from the board of directors. This step is needed to set the general direction of the plan, such as to add a new product line or to terminate a subsidiary.

Create a calendar of budgetary milestones. Specific due dates are needed to ensure that the management team creates their respective portions of the budget on a timely basis, so that these pieces can be rolled into the main budget model.

Create budgeting policies and procedures. This documentation is needed to give direction to those managers involved in the creation of the budget.

Preload the budget. In some cases, it is more efficient to supply managers with a preliminary budget model that already contains an estimated budget. The estimated budget is based on historical results, adjusted for inflation. Managers can then focus their attention on the more critical changes to the budget model.

Issue the preliminary budget model, with policies, procedures, and milestone dates, to the responsible managers. The person in charge of the budget then provides support to these managers as they adjust the supplied budget model.

Aggregate and revise the model. As budget segments are returned by managers, the segments are aggregated into a master budget model, which is then reviewed by senior management. These managers will likely mandate changes to the model, such as adjustments in capital spending or expense levels. These mandates necessitate a series of revisions by those managers who create the model.

Once all parties are satisfied with the budget model, the board of directors signs off on it and the accounting department loads it into the accounting software, resulting in budget versus actual financial statements.

Once a budget model has been completed, it is then used to control the operations of a business. This can be done in the following ways:

Report budget versus actual variances to management, so that the largest negative variances are investigated.

Pay bonuses based on compliance with the budget.

Only authorize expenditures if there is funding left in the budget to do so.